Political risk has been a feature in European markets for years. Lately, from Italy’s fiscal squabbles to
turmoil in the streets of France, it feels like the volume of political noise has risen. However, political risk is
not a reason to avoid European equities.

Europe today offers plenty of opportunities for bottom-up
stockpicking based on fundamental analysis, the key to investing success. But a thoughtful overlay of
political risk analysis is essential to complete the picture and reinforce investing conviction in these tense
times.

For equity investors, the Brexit saga is probably the number one political headache today. Brexit is
creating three major risks for companies. The first is trade disruption: firms that must move parts or
finished goods across the UK border could be vulnerable to severe, though probably temporary,
disruption in the event of a no-deal Brexit. Currency risk and the impact of pound on companies’ earnings
is the second major concern, while the third one is to UK economic growth that could suffer from
persistent uncertainty.

When researching stocks in the UK and across Europe, we ask whether a company is exposed to the
specific risks that we’ve identified. Then, we assess whether those risks are threatening its future cash
flows and, if so, to what extent they’re adequately priced into the company’s stock.

Some of the companies that are potentially most exposed to Brexit may not even be listed in the UK.
Peugeot of France, for example, both makes cars in the UK and sells more of its production to UK
consumers than do its main European-listed rivals. So it’s important that portfolio-level risk analysis takes
account of Brexit impacts on non-UK companies; you can’t judge a portfolio’s exposure to Brexit just by
looking at its weight in UK stocks.

There are two sides to the Brexit risk coin. Investors also need to consider what will happen if a
favourable Brexit deal is reached—or, conceivably, if the UK ends up not leaving the EU after all. These
outcomes would likely benefit UK stocks that have traded at a Brexit discount, as well as cyclical
European companies that have suffered amid recent risk aversion. Investors in European stocks need to
ensure that they are neither overexposed to Brexit downsides or underexposed to possible Brexit-related
market rallies.

In fact, we think many companies exposed to Brexit risks offer attractive return potential today. Take
Johnson Matthey, for example, which makes materials for auto catalysts that are enjoying growing
demand as emissions standards tighten. Or Marks & Spencer, the food, clothing and homeware retailer,
where new management is taking the measures needed to turn around performance, in our view. And
outside the UK, Peugeot is continuing to reduce costs both in its long-established units and the
businesses it acquired essentially for free from General Motors last year.
Of course, Brexit is only one political risk hanging over European markets today. From street protests in
France to governments in Hungary, Poland and elsewhere, the resurgence of populism in Europe is
challenging EU norms. As the May European Parliamentary elections approach, investors may become
concerned that further gains by antiestablishment parties could undermine the stability of the EU’s
institutions.

In our view these fears are overdone. The Italian government’s recent decision to abide by eurozone
fiscal rules, following the earlier example of Greece, suggests that populist rhetoric in the opposition often
gives way to pragmatism in government: the overriding political imperative to remain in the euro retains
strong popular support, as polls continue to show.

Still, investors need to be on the lookout for less well-publicized political risks that can have a real impact
on companies’ earnings. In Spain, for example, recent tax changes introduced by the center-left coalition
government have impacted some banks, and efforts to pass a budget this year will be complicated by the
politics of Catalan separatism.

Political risk is not a reason to avoid European equities. Europe today offers plenty of opportunities for
bottom-up stockpicking based on fundamental analysis, the key to investing success. But a thoughtful
overlay of political risk analysis is essential to complete the picture and reinforce investing conviction in
these tense times.